Portfolio Management. Suggested answers and examiner s comments. July Important notice

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1 s and examiner s comments Portfolio Management July 2014 Important notice When reading these suggested answers, please note that the answers are intended as an indication of what is required rather than a definitive right answer. In many cases, there are several possible answers/approaches to a question. Please be aware also that the length of the suggested answers given here may be somewhat exaggerated compared with what might be achieved in the reality of an unseen, time-constrained examination. Examiner s general comments The pass rate for this examination session was 61%. small number of excellent scripts attained high marks. andidates are advised to engage with the entire content of the study text for study and exam preparation. IS, 2014 Page 1 of 14

2 Section nswer all parts of Question 1. Select only one of the options,, or for each part. 1 (i) The concept of the real rate of return on an investment corresponds to: The nnual Percentage Rate (PR). The rate of increase in an investor s wealth after taking into account the erosion in the purchasing power of money associated with price inflation. The return after deduction of brokerage fees and taxes. The return measured as the sum of income and capital gains/losses. (ii) Which of the following is not a term which describes the face value of a plain vanilla bond? Par value. Redemption value. Market value. Principal value. (iii) put option: Offers the holder the right to sell the underlying asset in the future, at a predetermined price. Requires the holder to sell the underlying asset at a predetermined price. Offers the holder the opportunity to sell the underlying asset for a price equal to the option premium. Offers the holder the right to buy the underlying asset in the future at a predetermined price. (iv) The apital sset Pricing Model states that the beta value for the market portfolio: Lies between minus 1 and plus 1. Is equal to 1. Is equal to 0. Is always greater than 1. IS, 2014 Page 2 of 14

3 (v) Shorting an asset describes the practice of: Selling an asset below its market price. dvising clients to regard the asset as a poor investment. orrowing an asset in order to sell it at its current market price. uying an asset whilst agreeing to sell it back to the lender at a fixed price in the future. (vi) In futures markets, the term marked-to-market refers to: The declaration of a contract settlement price at the end of the trading session. The tallying of each individual trader s deals at the end of each trading session. The practice of adding up paper gains and losses for each trader at the end of each trading session. The practice of cash settling traders gains and losses on contracts at the end of each trading session. (vii) In the management of risks associated with fixed interest securities, the concept of duration is most appropriate for measuring the impact of: Yield changes on bond prices. hanges in the creditworthiness of bond issuers on bond prices. hanges in inflation on bond prices. allable options on bond prices. (viii) Which of the following offers the clearest example of a passively managed investment fund? viva European Property Fund. F& UK Smaller ompanies Fund. M&G Global Leaders Fund. Royal ank of Scotland FTSE 100 Tracker Fund. (ix) Which of the following ratios is the dividend yield? annual dividend per share share price annual dividend per share earnings per share annual dividend per share gross dividend per share annual dividend per share gross profit IS, 2014 Page 3 of 14

4 (x) private equity placing is a sale of new shares: y a private company that is not listed on a recognised stock exchange. y a listed company that is restricted to its existing shareholders. y a listed company to pre-selected, usually institutional, investors. On preferential terms to the directors of a listed company. (Total: 10 marks) s (i) The rate of increase in an investor s wealth after taking into account the erosion in the purchasing power of money associated with price inflation. (ii) Market value. (iii) Offers the holder the right to sell the underlying asset in the future, at a predetermined price. (iv) Is equal to 1. (v) orrowing an asset in order to sell it at its current market price. (vi) The practice of cash settling traders gains and losses on contracts at the end of each trading session. (vii) (viii) Yield changes on bond prices. Royal ank of Scotland FTSE 100 Tracker Fund. (ix) annual dividend per share share price (x) y a listed company to pre-selected, usually institutional, investors. In Section, candidates are advised to read the different options to each question carefully before choosing an answer. IS, 2014 Page 4 of 14

5 Section nswer all ten questions. 2 In financial theory, all investors are assumed to be risk-averse, including those who are prepared to invest in very risky assets. Explain why big risk takers can still be considered risk averse. References to risk-averse investors in financial theory should not be interpreted in the everyday sense of an unwillingness to take risks. The assumption is that all investors, faced with different portfolios offering the same expected return, will choose the one with the lowest risk. Even investors who are prepared to take large risks are still considered risk-averse because they are assumed unwilling to take risks which do not offer the prospect of a return commensurate with the risk. High-risk takers will be drawn toward investment opportunities offering high expected returns. ut they will still choose the investment with the lowest risk relative to the target return. This question was generally answered quite well given that the concept is quite subtle. 3 Explain why a yield curve typically shows that yields on long-term fixed interest securities are higher than yields on short-term securities. Yield curves provide graphical representations of yields on fixed-interest securities where differences are solely a function of terms to maturity. Longer-term bonds have more exposure to market risk; their prices are more sensitive to changes in yields. From the vantage point of investors, this sensitivity amounts to an additional risk factor. Longer-term bonds therefore typically offer higher yields because they include an element of reward to investors prepared to carry this risk. This question was among the weaker answers. mong the issues were poor quality diagrams drawn free hand and without the axes being properly specified; confusion between the term structure and the relation between price and yield in relation to a particular bond. IS, 2014 Page 5 of 14

6 4 Explain four characteristics of commercial paper (P). P is sold by companies in the money markets for the purpose of borrowing funds. It is a mechanism for short-term borrowing with maturities as little as a day and up to one year. It is issued on a pure discount (zero-coupon) basis with yields dependent on the scale of the sale price discount to face value. Reflecting their greater credit risk compared to government securities, the yields are higher than for government-backed Treasury bills. Other factors were permissible for inclusion in the four characteristics, such as it being normally unsecured, assigned ratios by agencies such as Moody s, tradable in principle although in practice infrequently, and can take asset-backed form. The quality of answers given was reasonably good with a high percentage of candidates scoring high marks. 5 Explain what is meant by the term momentum investing. momentum investor seeks to ride waves of momentum-driven asset prices, buying on an upward momentum, and shorting in cases of downward momentum. The rationale for momentum investing is the view that price movements have a propensity to build on themselves for reasons other than information about economic fundamentals. The momentum investor aims to recognise instances where asset prices are subject to momentum and to act accordingly. The aim is to discover evidence of momentum as early as possible. The dilemma is that acting early makes it more likely that the expected momentum does not emerge. This question was reasonably well answered with respect to the first paragraph of the suggested answer. Fewer candidates managed to discuss the importance of timing to the momentum investor. IS, 2014 Page 6 of 14

7 6 riefly outline the significance of covered interest rate parity theory in the determination of forward currency rates. Forward currency rates refers to rates of exchange agreed in the present on currency transactions that are set to occur in the future. ccording to covered interest-rate parity theory, the percentage difference between the spot and forward currency rates will correspond to the percentage difference between the money market rates on the two currencies in question. The lower interest rate currency is more expensive in the forward market, resulting in a situation where it is not possible to lock in gains associated with the interest-rate differential (IR) by entering into a forward exchange. This question was generally poorly answered with a significant number of candidates either not attempting the question or not scoring any marks as they did not properly explain the meaning of terms which are conceptual rather than representative of procedures. 7 Outline the difference between execution-only brokerage and full service/discretionary service wealth management. Execution only is the most limited form of brokerage with the broker s role limited to carrying out orders received from clients in return for fees. It is the brokerage service favoured by investors who are confident enough to make their own decisions concerning the management of their investments. Full service/discretionary service wealth management goes beyond execution and focuses on devising investment strategies tailored to specific client investment needs, formulated in consultation with the client and subject to regular reviews. The investor gives the manager a great deal of discretion in relation to the investment strategy and management decisions. s such, charges for full service/discretionary service brokerage are higher than for execution only brokerage. This question registered the highest average mark of all the questions in Section, which might suggest that candidates may be much more comfortable with describing and defining issues of a practical or procedural nature. IS, 2014 Page 7 of 14

8 8. Explain the meaning of the term synergy in relation to corporate mergers and acquisitions. The notion of synergy, in general terms, is summed up in expressions such as = 5 or the whole is greater than the sum of the parts. The logic applied to corporate mergers is that unifying two or more operations facilitates efficiency gains that are not attainable by companies operating alone. mong the most often cited sources of synergy are the realisation of economies of scale associated with the larger operation, the pricing benefits (in relation to suppliers and customers) of possessing increased market power, and a potential reduction in the cost of capital if the larger merged entity is seen as being less risky. Many answers either did not define synergy or did so in an extremely vague way. 9. Identify and explain the cash flows that contribute to the determination of the dirty price of a plain vanilla bond. The repayment value, an amount paid to the owner of the bond on the maturity date. stream of coupon, or interest, payments occurring at regular intervals. It is the present value of these payments that is reflected in the bond price. Sellers of bonds are entitled to part of the next coupon payment with the amount depending on the time elapsed since the last payment relative to the time remaining until the next. This affects the price at which the bond is sold, producing its dirty price. The standard of many answers to this question was average. Most fell short on the issue of the accrued interest. IS, 2014 Page 8 of 14

9 10 company has issued commercial paper with the following characteristics: principal value of 100,000. term to maturity of 91 days. yield that is 0.3% above the yield on three-month UK treasury bills. alculate the sale price of the commercial paper assuming that the current annual yield on threemonth treasury bills is 0.45%. You can use the following formula: Yield = 0.75% This question was generally well answered, registering the second highest average mark for Section. 11 company is paying a variable rate of interest on a ten-year loan of 1% above LIOR. It is concerned that interest rates are set to rise and, as a result, has decided to fix the rate using a 10- year interest rate swap. bank quotes a 10-year swap rate spread of 3.0%-3.1%. alculate the fixed rate that the company pays if it enters into a swap agreement. Under the swap, the company pays a fixed rate of 3.1% and receives LIOR. The receipt of LIOR neutralises the exposure to interest-rate variability on the loan. Hence the company pays a fixed rate of 3.1% plus the 1% premium above LIOR; thus a fixed rate of 4.1%. This question asked candidates to calculate a swap rate. Over a third of candidates did not attempt this compulsory question. Time constraints possibly played a small part with students wanting to get on to Section, but it exemplifies a weakness in the knowledge of swaps. The question is numerically simple, requiring the addition of 3.1 and 1. Hence, it is clear that perhaps the difficulty is conceptual. Only one candidate attained the full four marks. The topic is covered in hapter 9 section 1.2 and 1.3 of the study text. IS, 2014 Page 9 of 14

10 Section nswer two questions only. 12 The table below presents the monthly returns for two companies over the last five months. Month ompany Return ompany Return 1 4.0% 2.0% 2 0.2% 1.0% 3-1.6% -0.3% 4 3.3% 2.0% 5-0.5% 1.5% (a) alculate the average monthly return for each company. (2 marks) (b) alculate the monthly standard deviation of returns ( ) for each company and discuss whether or not the levels of risk are consistent with the average returns. Use the following formula to calculate the standard deviation of returns: (10 marks) (c) The correlation coefficient of returns between ompany and ompany ( ) is (minus 0.238). alculate the covariance of returns ( ) using the formula: (2 marks) (d) alculate the return and standard deviation of return for a two-asset portfolio equally weighted between ompany and ompany, and compare the portfolio risk to the risk of two assets. Use the following formula to calculate the portfolio standard deviation of returns: (11 marks) (Total: 25 marks) IS, 2014 Page 10 of 14

11 (a) (b) Month ompany Return ompany Return 1 4.0% 2.0% 2 0.2% 1.0% 3-1.6% -0.3% 4 3.3% 2.0% 5-0.5% 1.5% verage Return 1.08% 1.24% Standard eviation 2.19% 0.85% ompany has generated a lower average return: 1.08% compared to 1.24%. Yet, its standard deviation of returns is higher indicating that the actual monthly returns depart from the average to a greater degree. This means that the actual return on company is subject to greater uncertainty, or risk. This is inconsistent with a basic observation of investment analysis that assets offering higher returns normally require investors to accept a greater degree of risk. (c) orrelation coefficient x x = Therefore, the degree of correlation between the two assets is approximately zero. (d) Equally weighted portfolio Return 1.16% Portfolio variance Portfolio standard deviation 1.07% The critical point is that the two-asset portfolio offers a higher return than but with less risk. However, it is still inferior to which offers a higher return for less risk than the portfolio. Rational investors would invest solely in. This ought to lead to a fall in the price of (and therefore a rise in s rate of return) and an increase price of (and therefore a fall in the rate of return). The price adjustments ought, in theory, to bring about comparative returns consistent with the levels of risk. Note Regrettably, an error was included in the scenario of the question with six months stated in the text and data for five months given in the table. The correct form of the question is shown here. The error was noted before the marking was undertaken and no student was disadvantaged. Question 12 registered the highest average mark of the three Section questions. One candidate attained full marks. IS, 2014 Page 11 of 14

12 13 (a) The efficient market hypothesis offers a model of capital market price efficiency that emphasises three levels. Outline the main claims of the theory and explain the distinctive characteristics of each level. (10 marks) (b) It has been claimed that market efficiency means investors are not able to profit systematically from the use of different types of market information. Evaluate this claim. (15 marks) (Total: 25 marks) (a) EMH argues that asset prices are the outcome of investors making decisions on the basis of the information available. Investors form expectations about future prospects based on the information available; and, out of this process, market prices emerge. Weak form efficiency: States that prices fully reflect the past prices and related trading data about asset price movements and trading volumes. Semi-strong form information: Includes the technical market data. It also incorporates other types of information broadly categorised under the heading of fundamental information. t the level of the company this embraces accounts, ongoing updates on earnings and other performance metrics, announcements concerning dividend payments, capital issues, new initiatives, assessments by corporate analysts, etc. There is also information on broader sector developments such as overall growth prospects, competition and risks. Finally there is the macroeconomic environment. There is a presumption in semi-strong efficiency that this information of available to all market participant on an equal footing; it is publicly-available information. Strong form information: onsists of adding inside knowledge to the information set and posing the issue of whether prevailing prices also reflect the significance of this information. In effect, the strong form poses the issue of whether prices are efficient in relation to all information. (b) The key contention of EMH is that financial markets incorporate the value effects of information so rapidly that individual investors cannot expect to systematically profit from acting on the information. Investors can t respond rapidly enough to profit from the price adjustments. The upshot is that investors are unlikely to perform better than the risk-adjusted expected return on a systematic basis. For instance, trade execution systems are faster than ever, suggesting that price adjustments to new information becomes even more rapid, thereby reducing the window of opportunity still more. Technical analysts question this claim, arguing that it is possible to discover information in the past market data that has yet to be fully incorporated into prices. nalysts of fundamental data likewise believe that clues to profit making lie concealed in the data and can be discovered by the attentive investigator. Examples are those who employ top down and bottom up approaches to strategic asset allocation. The former suggest that it is possible to anticipate structural shifts in investment habits such as those tied to the business cycle. The latter focus on developments in certain metrics grounded in the fundamental information such as price-earnings and price-to-book ratios. The discussion about profiting from inside information arouses less interest aside from recognising the questionable legality of trading on the basis of such information. IS, 2014 Page 12 of 14

13 recent phenomenon that has prompted further interest in the issue of market efficiency is that of high-frequency trading (HFT). Even supporters of the EMH have long accepted that there are certain price anomalies that are difficult to explain (size and calendar anomalies being the most obvious). HFT involves the use of complex data-analysis algorithms to identify small asset price anomalies in masses of data and using super-fast trade execution technology to profit from the anomalies. The anomalies are minute and fleeting; gains accrue from being able to identify large volumes of these anomalies and using high levels of leverage to arbitrage a worthwhile return. HFT indicates that the modern trading and dataanalysis architecture facilitates profit making from price anomalies that were previously too elusive and/or too small. Question 13 was the most popular choice in Section. Other relevant points given in candidates answers were marked. 14 iscuss the advantages and disadvantages of the apital sset Pricing Model (PM). (25 marks) Risk-free return represents a baseline minimum expected return. Investors will not take risks if they don t expect to exceed the risk-free return. The market risk premium is a component of the expected return that is a function of the performance of the market portfolio. The asset beta is a coefficient expressing the scale of the assets exposure to systematic risk. It determines the impact of the risk premium on the expected return. High betas indicate that the market return should exert an amplified effect on the investment return whereas betas below 1 indicate more muted effects. dvantages One advantage of PM is that it entails simpler computational procedures. Early portfolio theory produced portfolio risk measurements incorporating multitudes of variance and covariance numbers. With PM the risk free rate and market return of universal. The only variable is beta. lso, portfolio betas can be obtained using straightforward weighted average calculations, meaning that minimal amounts of additional information are required to formulate expected return prediction for large portfolios. nother advantage is its intuitive appeal. Presenting the scale of risk in terms of a single coefficient makes ranking and comparison more straightforward intellectual exercises. The PM provides a persuasive case for ignoring the detail of individual investments and focusing on the systematic risk factors. This helps encourage the conviction that the effort needed to manage large portfolios is feasible. IS, 2014 Page 13 of 14

14 isadvantages PM is only useful if we are prepared to accept the assumptions that investors are in general highly efficient, employing the advantages of diversification to the full and assessing assets solely in terms of the market risk. In this sense it may not be so useful for analysing small portfolios. rguably the older portfolio approach is better with its stress on total risk. Some critics suggest that it encourages the development of passive investment styles because it suggests that the market portfolio is the most efficient, and that risk can be managed simply by means of hedging or leveraging on the basis of the risk-free rate. Question 14 was the least popular choice, and the lowest scoring of the Section questions. The question did not ask for a detailed discussion of the assumptions underpinning the claims of the PM, but asked candidates to focus on how it is, or can be used. significant number of candidates suggested that one of the limitations of PM is that it examines investment over a single period of one year. This misrepresents the meaning of the single-period assumption. The PM does assume a single-period investment horizon. ut it s a rather subtle point of methodology associated with the idealised rational investor that forms a key component of the Model. In the basic version of the PM, all investors are assumed to conform to the idealised investor endowed with stable consumption functions and stable measures of security systematic risks. The act of investment (effectively an act of foregoing immediate consumption) is a one-off event over a single, but unspecified, period at the end of which investments are liquidated for the purpose of consumption. In practice, the trade-off between consumption and investment is more complex. sset return distributions change in unforeseen ways and consumption functions vary. Investors adapt asset portfolios to the evolving investment environment, consumption preferences and incomes. They demand premiums for non-market risk factors such as asset illiquidity and hedge exposures of consumable wealth in the context of uncertainty. These factors imply that investment is effectively a multi-period phenomenon; and, therefore, the basic PM represents a significant simplification. This methodological point goes beyond the discussion in the text, it is important to note that the model assumption does not refer to a standardised length of time. The scenarios included here are entirely fictional. ny resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental. IS, 2014 Page 14 of 14